Document Type

Article

Publication Date

2012

Abstract

This Articlep resents a case study in how complexity arisingf rom the evolution and prolferation of a financial innovation can increase systemic risk The subject of the case study is the securitization of home loans, an innovation which played a critical and still not fully understood role in the 2007-2009 financial crisis. The Article introduces the term 'fragmentation node" for these transaction structures, and it shows how specic sources of complexity inherent in fragmentation nodes limited transparency andflexibility in ways that undermined the stability of the financial system. In addition to shedding new light on the processes through which financial innovations become so complex and how that complexity contributes to new sources ofsystemic risk, the Article considers the tools regulators will need to tackle these sources of systemic risk. The policy analysis shows that disclosure, a tool commonly used in financial regulation, will not suffice. At times, regulators should target these new sources of systemic risk directly by seeking to reduce the length and complexity of the chain connecting investor and investment. The Article suggests some modest steps regulators could have taken prior to the 2007-2009 financial crisis, such as a transaction tax targeting serial fragmentation nodes, to illustrate how such reforms might work in practice. It also explains why the dynamics revealed in this case study are almost certain to arise again, even if in slightly diferent form.

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